Don’t yield to income! Part II

Don’t yield to income! Part II

Back in March with the help from the quant department in one of Australia’s leading investment banks, we prepared some data that allowed us to quantify the impact that lower interest rates have had on asset prices, in particular on the price of the S&P ASX 300 Index.

The S&P ASX 300 index measures the largest and most liquid 300 companies trading on the Australian stock exchange. So as a proxy for capital growth, this fits the bill perfectly.

As a follow-up to that work, given the recent correction in the market, we again prepared a similar data-set.  As you can see below, the market as measured by the S&P ASX 300 index, for the current financial year,  has returned 25.8 per cent capital growth since June 30, 2010 – a five year period.

It was almost two years ago that we described a scenario in which investors would find rates on term deposits sufficiently unappealing that they would be forced out of cash and into other asset classes such as equities. Fast forward to today and we have witnessed that play out. Across the investment asset spectrum and across the world, the impact of central bank intervention has been felt.

Perhaps the table above goes some way to explaining the impact of low interest rates through investor migration. Interestingly, but not unexpected, is that during the five-year period under review the ASX300 Forward Earnings (FY1) index has declined by 1.9 per cent. That’s right, earnings have fallen, largely explained by resource and energy stocks, which was previously covered in another blog post. In other words, all of the gains in the broader market have been driven by what is known as multiple expansion (this is represented by the right hand side column of the table).

‘Multiple expansion’ is a euphemism for ‘people willing to pay more’.  As a result it is worth noting Price/Earnings’s have expanded by nearly 28 per cent since June 30, 2010.

This draws one simple conclusion; our buoyant stock market is not justified by its earnings growth, and signs of bubble-like activity elsewhere suggest that underlying fundamentals (earnings/cash flow improvement) are not driving the market in aggregate, more central banks.

Of course, underneath the broad indexes lies a number of businesses that are compounding their earnings at well above market average rates. It’s these businesses we continue to look out for and buy for investors in our funds.

Russell Muldoon is the Portfolio Manager of The Montgomery [Private] Fund. To invest with Montgomery, find out more.